What Cryptocurrencies Mean For Venture Capital

Future of cryptocurrencies still up in the air, particularly regarding regulation.

Seldom does a day go by without a prominent headline on cryptocurrencies, which is not surprising given the rapid rise of Bitcoin and other cryptocurrencies year to date in 2017.

It’s easy to see why cryptocurrency is garnering such attention. Bitcoin presently trades up 8.0x year to date to above $8,000 per token. Ethereum is trading more than 40x above where it started at the beginning of the year.

Of course, the sometimes spectacular volatility has also grabbed headlines as the fledging ecosystem goes through a period of rapid development. Blockchain technologies, which underpin cryptocurrencies and have a wide range of potentially disruptive applications, have also received plenty of attention in 2017. This has been fueled by another phenomenon that has emerged in 2017 - the initial coin offering (NYSE:ICO).

The volume of capital that has been raised via ICO year to date in 2017 has venture capitalists paying attention, as some industry participants have postulated that it has the potential to disrupt the way early-stage venture financing will be structured in the future.

As of November 17, 211 ICOs have raised a total of $3.5 billion, according to CoinSchedule. The amount of capital hauled in by these crypto-asset and blockchain-related projects through ICO eclipsed that of seed-stage venture capital (VC) funding for internet companies year to date in 2017.

The magnitude of this number certainly has us, and plenty of VC’s, paying attention. Many in the industry have been speculating whether raising funding through ICO might impact the traditional venture capital model. The same questions were raised when crowdfunding platforms began to gain momentum back in 2008-2009.

Comparisons can be drawn between crowdfunding platforms and ICO’s, but a key difference is the staggering amount of capital that individual projects have been able to raise through ICOs in 2017. In our opinion, some of these nascent projects raised capital in excess of what they rationally need to launch their projects. At the other end of the spectrum, we’ve also seen some later-stage companies take advantage of the market’s interest in ICO’s and raise growth capital through the issuance of tokens rather than raise a traditional growth round that would have been dilutive to their ownership stake.

It is still early days, but various funding models will likely co-exist as they always have. At present, ICO’s remain an unregulated area, and if the inflows persist, regulators will certainly step in and establish guidelines. There are also governance issues to consider with ICO’s. In ICOs, it’s hard to tell who the actual underlying shareholders of the assets are, which creates a unique set of challenges. Compared to traditional equity, the stakeholders are well-known, there is often a board of directors, and there’s very clear governance.

To date, very little in the way of institutional capital has been invested by traditional venture capital firms in either blockchain related technologies or crypto-assets. Blockchain, the infrastructure that underlies cryptocurrencies, relies on a public distributed network that is maintained by each network participant. Market participants across many different industries are evaluating the potential applications of blockchain technologies.

Banks and other financial institutions are paying particular attention, given the technologies’ potential to revolutionize and streamline payments and other financial transactions. Blockchains create a continuous list of records that are distributed, yet linked and thus viewed to be secure. Ultimately, blockchains have the potential to reduce the need for the middleman, such as banks, as the two parties involved in any given transaction could deal directly with one another.

This, in effect, could streamline transaction costs given each transaction would be recorded on a secure, shared database that is unchangeable, providing an alternative to current banking processes which are expensive and burdensome from a compliance perspective.

Already, we can see how this kind of decentralized architecture makes sense. That said, much of the investment interest to date has centered on currency speculation, such as the future of bitcoin and other cryptocurrencies. Until recently, there hasn’t been significant institutional interest in the space.

What is clear is that it is still early days. Cryptocurrencies have high volatility and low liquidity, and how the regulatory framework might evolve is a significant unknown. Utilizing cryptocurrencies for everyday transactions has not yet seen massive market uptake given relatively few merchants accept it as a method of payment, and the fact that compared with using a credit card, the processing times and transaction costs (at least today) are slower and higher.

While many have focused on currency speculation, we’ve directed our attention to blockchain technologies. Blockchain has already proven to be a useful technology. Now it’s about refinement and uncovering how the technology can be applied. The interest in ICOs, which are funding blockchain-related projects, has demonstrated that many others believe in the potential utility of the technology as well. We’re firm believers that blockchain’s utility is immense, and that with time, the use cases will be proven out.

Important Information

Alternative investments involve specific risks that may be greater than those associated with traditional investments; are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices; carry additional risk of loss, including possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments; and are generally considered to be illiquid due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information.